Brasil Foods A Bipolar Brazil Play

There's an old joke that goes something like this - what is a long-term investor? A short-term investor that won't admit a mistake, take a loss, and move on. I don't happen to subscribe to that point of view, but I do admit that Brasil Foods (NYSE:BRFS) is not the easiest stock to own as Wall Street wavers between breathless enthusiasm for emerging markets and rank skepticism about those same markets.

Brasil Foods absolutely has real challenges today, but the long-term potential for this Brazil-based global food company is enough to keep me interested in the shares.

Second Quarter Results Really Not That Surprising

Second quarter numbers came in broadly in line with prior management guidance, and there really weren't many surprises. While I've seen some bearish analysts gloating over the poor EPS performance, the reality is that earnings were thumped by non-cash currency expenses and EBITDA essentially matched an average of estimates.

Revenue rose 9% from last year (and 8% from the first quarter) as the company saw minimal domestic volume growth but higher domestic pricing and vice versa for exports (good volume, weak pricing).

Margins and profits were definitely problematic. EBITDA fell 28% from the year-ago level, but rose 6% sequentially. Brasil Foods saw meaningful erosion in domestic operating margins (down about one-third sequentially), due in large part to significant labor cost increases - something other Brazilian companies like Arcos Dorados (NYSE:ARCO) have also reported. Export margins turned around from the first quarter, but are still substantially lower on a year-on-year basis.

Synergies - A Long-Term Driver, Or A Mirage?

I suspect that a lot of the disappointment on these shares has centered around the slow-to-materialize synergies from the Sadia-Perdigao merger. Antitrust compliance issues certainly haven't helped, as they have increased costs in 2012 with no offsetting revenue growth. Longer term, the company should still see significantly better EBITDA margins, but the cost of the asset swaps with Marfrig (OTCPK:MRRTY) are taking their toll today, as are higher growing costs.

The Future Has To Be About Processed Food

One of the parts of the Brasil Foods story that puzzles me is the extent to which analysts seem to believe that the company is not going to change much in the years to come. Right now Brasil Foods relies heavily on raw meat exports to markets like Japan and Saudi Arabia, and that is a ridiculously tough business in which to establish sustainably good margins. Yes, Tyson (NYSE:TSN), Smithfield (NYSE:SFD), and Pilgrim's Pride (NYSE:PPC) do show that there is some long-term growth in selling protein, but it's not an exceptionally lucrative business.

The key for Brasil Foods, is the extent to which it can resemble Hormel (NYSE:HRL) or Nestle (OTCPK:NSRGY) in the future. To that end, I wouldn't ignore the company's significantly better processed food sales growth within Brazil, nor the lengths the company still has to go in making its exported processed foods business a real driver. With that in mind, I wouldn't be surprised to see the company look to make deals for packaged/processed food businesses in markets like North America and Asia.

The Bottom Line

To be blunt, if Brasil Foods continues to operate more like Tyson or Smithfield with respect to the export markets, this is not an especially exciting long-term story. Yes, Brazil has certain inherent advantages as an agricultural exporter that will help Brasil Foods, but similar advantages in countries like Thailand will likely whittle down Brasil Foods' expected returns to something more Tyson/Smithfield-esque.

On the other hand, building a brand-based processed food business like Hormel (or Nestle) changes a lot. Not only do packaged food businesses sport higher returns on capital and higher free cash flow conversion rates, but also lower discount rates. What's more, as countries like Brazil see higher standards of living, that generally translates into more shopping down the center aisles (the packaged/processed foods) and less along the periphery.

If Brasil Foods' mix stays basically as is, this is a stock with a mid-teens fair value and one that I wouldn't recommend owning. If you believe in a branded Brasil Foods future, though, the fair value can quickly move in the low-to-mid $20's. I'll take a middle road for now, acknowledging the near-term commodity risks and exposures, while also holding out optimism for the company's long-term transformation. With that in mind, I think fair value for these shares ought to be in the high teens to low $20's today.